THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES THE ... · Net trade receivables (in 2010) $125...

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THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES THE INSTITUTE OF CHARTERED SECRETARIES AND

ADMINISTRATORS

International Qualifying Scheme Examination

CORPORATE FINANCIAL MANAGEMENT JUNE 2012

Time allowed – 3 hours

Section A – Compulsory case study

Section B – 5 long questions (attempt any 3)

DO NOT OPEN THIS PAPER UNTIL INSTRUCTED TO DO SO BY THE INVIGILATOR

Important Note: Candidates are allowed 15 minutes reading time to read through the question paper before the commencement of the examination between 9:15a.m.-9:30a.m. During the reading time, all candidates must be silent and must not write or mark anything on their question papers or answer books. Candidates must close all their reference books, notes or other unauthorised materials and put these under their chairs. If any candidates write or make any marks during the reading time, or if they speak or in any other way communicate with anyone either in or outside the examination hall during this period or read any unauthorised materials, they will be disqualified from continuing this examination paper. Once candidates have opened the question paper, they are not allowed to leave the examination hall until 10:00a.m.

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SUBJECT NO. 16J

CORPORATE FINANCIAL MANAGEMENT JUNE 2012

The examination paper is divided into TWO sections. Section A is compulsory and carries 40 marks. Candidates should attempt THREE questions from Section B, all of which carry 20 marks each. You should allow yourself approximately 70 minutes in total to answer the question in Section A, and 35 minutes for each of the questions attempted in Section B. Unless otherwise stated, $ denotes Hong Kong dollars. All interest rates are annual rates. Round your numerical answers to two decimal places. Friday morning 1 June 2012 Time allowed: 3 hours

SECTION A

(Compulsory – answer ALL questions in this section)

1. Sandy So Limited (SSL) was founded in 1961. It is a medium-sized non-private company. It has successfully developed a healthy relationship between retail-chain and catering networks. SSL has adopted activity based management which not only enhanced its efficiency and transparency in managing the costs and expenses as a whole, but also provided the best services to the company’s valuable customers and strategic partners. As a result, SSL became a strategic food services distributor consultant providing integrated services in Hong Kong and Mainland China.

In the past five years, a series of bank and insurance company failures triggered a global financial crisis. SSL also experienced some difficulties in such trading environment. This was mainly due to the external factor of the international unstable economy and the local factor of the increasing number of competitors in the food and beverage industry. To enhance its reputation and increase sales, SSL management decided to provide the most comprehensive sole agent value-added services and a wide-range of marketing plans, including market research, analysis of consumer buying habits, packaging and public relation activities.

SUBJECT NO 15M

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Up to the end of the reporting period 31 December 2011, there were 38,000,000 ordinary shares issued with $1 par value. Since most of the directors have been reluctant to take on debt financing, there is no debt in SSL’s capital structure. The table below shows earnings and dividends for SSL over the past five years.

Year 2005 2006 2007 2008 2009 2010

Earnings per share 190 cents 220 cents 235 cents 255 cents 260 cents 260 cents

Dividends per share 154 cents 171 cents 187 cents 203 cents 219 cents 233 cents

Dividends are declared in December each year and paid in January in the following year. The current dividend policy is that growth rate in dividends is equivalent to the average growth rate in earnings over the past five years. However, SSL’s shareholders expect an after-tax return of 20% on their investment. SSL always takes account of this expected rate of return in all projects. The growth in earnings per share represents the market intelligence, effective environment adaptation and the spirit of new development in the SSL management team. A new director, Fanny, a Certified Public Accountant, has recently been appointed as a board member. With this new appointment, the SSL management team has seven members. In a regular management meeting, the Directors (Anna, Ben, Candy, Danny, Eric, Fanny and the Managing Director Gina) discussed the implications of earnings per share for 2009 and 2010. They also shared their views on dividend and financing policies. Some directors worried about the company’s future earnings ability, and made some suggestions. Their suggestions might also have some impact on the future dividend policy.

In line with the investors’ objective of dividend maximisation, Anna recommended paying out all earnings as dividends.

Ben and Candy suggested paying reduced dividends of 25% and 50% respectively from earnings and keeping the remaining portion for future capital investment projects.

Danny believed in paying zero dividends and retaining all earnings for future capital investment projects so that the company’s expansion programme would be better. He also suggested a share split to make shares seems more affordable to small investors. He emphasised that implementing his ideas would have a positive impact on the share price directly.

Eric disagreed with Danny and thought that it would be better to pay scrip dividends to shareholders to keep cash for future investment opportunities.

Fanny thought that the pure equity financing policy which had already been in place for many years was no longer suitable. She believed that both equity financing and non-equity financing should be considered as a way for SSL to raise capital.

Gina agreed with Fanny and suggested that a fundamental change in financing policy was needed to tackle the future unstable economic condition.

The management is now considering these alternatives. They are still unable to come to an agreement on the dividend and financing policies. SSL's expected market return is 9% while the risk free rate is 4%. SSL’s beta is currently quoted at 1.6 by an independent consultant. This is not expected to change in the foreseeable future.

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In a special management meeting, Anna and Ben suggested investing $40 million in Project X which is expected to increase profits before interest and tax (PBIT) by $10 million. To finance the $40 million investment in Project X, Fanny and Gina suggested arranging a bank loan at an interest rate of 2.5% above the prime rate rather than issuing shares. The prevailing prime rate is 5.5%. Other directors suggested issuing ordinary shares of 40,000,000 shares at $1 each. At the reporting period ended 31 December 2011, the profits before interest and tax were $80 million. The profits tax rate is 20%. REQUIRED: As the Company Secretary of SSL:

(a) Evaluate the shareholders’ expectations for the share price according to SSL’s current dividend policy.

(8 marks)

(b) Assuming that SSL will announce a change in dividend policy by adopting Candy’s suggestion after the management meeting, evaluate the shareholders’ expectations for the share price under the dividend growth model. State any assumptions you make.

(8 marks)

(c) Considering the suggestions made by Danny and Eric, critically discuss the potential impact on SSL of paying scrip dividends and performing a share split.

(10 marks)

(d) For Project X, write a memorandum and evaluate which financing approach, equity financing or non-equity financing, is more appropriate. Discuss your arguments with the relevant computations.

(14 marks)

(Total: 40 marks)

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SECTION B

(Answer THREE questions from this section)

2. You are the Finance Manager of Wing Lee Company Limited (WLCL), a company which has produced and sold healthy tea bags on credit since 2000. WLCL sells its products to many shops in Hong Kong. Up to now, it has not set up a policy about early settlement for trade receivables. Some basic information is listed as below.

Variable cost $6 per box

Price $10 per box

Net credit sales (in 2010) $750 million

Net trade receivables (in 2010) $125 million

Discounts for early settlement Not available

Cost of debt in financing trade receivables

18% per year

During the current year, WLCL’s cash flow seemed to be unhealthy. In order to improve the cash flow, director David Chan suggests offering a 5% discount for early settlement. He expects 80% of trade receivables will be settled early in order to take the discount. He also estimates that sales and trade receivables will both increase by 15% after the implementation of this new policy. REQUIRED:

(a) Evaluate and explain to the management team whether the early settlement policy should be adopted.

(10 marks)

(b) The management team needs to consider the new credit policy thoroughly before its

implementation.

With the information given above, discuss what issues the management team should

take into account in making its decision.

(10 marks)

(Total: 20 marks)

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3. You are the Chief Financial Officer (CFO) of Tango Company Limited (TCL), a listed company which is in decline. A competitor, Wendy Group Company Limited (WGCL), which is listed in Hong Kong, has decided to make a takeover bid for TCL.

At the end of last year, the share prices of WGCL and TCL were $6 and $15 respectively. The

total number of shares issued were 72 million and 20 million respectively. WGCL and TCL have agreed two alternatives for the takeover deal. In the first, WGCL will offer three WGCL shares for one TCL share. In the second, WGCL will pay $18 per share cash directly to TCL shareholders.

WGCL expects that the takeover will generate additional present value of $50 million as a whole. REQUIRED: (a) Advise the shareholders of TCL which alternative they should select.

(12 marks) (b) How can the expected additional present value generation of $50 million be

achieved? What are the barriers to this achievement? (8 marks)

(Total: 20 marks)

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4. You are the Chief Financial Officer of King Royal Limited (KRL), which is a public company in Hong Kong. You are evaluating two mutually exclusive investment projects which were recommended by the board in the last management meeting. You are now preparing an analysis which you will present in the next management meeting.

The following information, which has been prepared by external consultants, lists out the net cash flow of the two projects, Project Apple and Project Orange.

Year Project Apple ($M) Project Orange ($M)

0 -300 -320

1 250 20

2 79 50

3 81 120

4 64 399

REQUIRED:

(a) Advise KRL which projects should be accepted using: (i) the net present value method (NPV) if the discount rate is 10% or 20% and (ii) the payback method. State any assumptions.

(15 marks)

(b) Analyse your results in part (a) above. (5 marks)

(Total: 20 marks)

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5. Rico International Holding Limited (RIHL) is a local private company which sells goods to many countries. The local currency is the Hong Kong dollar.

This morning, RIHL sold goods to its largest UK customer, Berry and Au Limited (BAL), which is a listed company in UK. The invoice amount is £2,000,000. At the invoice date, the spot rate is $12.80/£ ($ or HK$ should be consistently used in this question) and the invoice amount is equivalent to $25,600,000 ($ or HK$). The payment due date is three months from the invoice date. The three-month forward rate is quoted as HK$12.50-12.60 = £1.00. (HK$ or $ to be consistently used in this question) . The company’s serving bank, the Hong Kong and Kowloon Bank (HKKB), has quoted the three-month borrowing rate for pounds and the three-month deposit rate for Hong Kong dollars as 5% and 1% respectively.

The Financial Controller of RIHL, Raymond, expects the Hong Kong dollar exchange rate per

pound will drop by 8% over the coming three months. The management asks Raymond to make a proposal to reduce the risk through the foreign exchange market or the money market. REQUIRED:

(a) Raymond is required to fully hedge / set off the potential exchange loss with the two

alternatives. Evaluate these two alternatives with calculations. (Assume that Raymond’s expectations of the exchange rate after three months are correct.)

(15 marks) (b) Foreign exchange exposure should be managed properly in order to reduce the risk of

loss. Discuss this statement.

(5 marks)

(Total: 20 marks)

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6. Red Iron Holding Company Limited (RIHCL) is a local listed company. It has identified a takeover target, Yellow Copper Limited (YCL), in Hong Kong. After the board meeting, all directors agreed to acquire YCL to increase shareholders’ wealth. Due-diligence is being performed. The announcement will be made very soon.

On Day 1, the management of RIHCL met secretly and agreed an offer price at $7.50 for each YCL share. It estimated that RIHCL will benefit from the economies of scale with present value of $22 million to be generated after the takeover. The current share price of YCL is $6 with 12 million shares in issue, while RIHCL’s current share price is $9 and it has issued 15 million shares.

On Day 8, RIHCL announced its intention to takeover YCL at $7.50 per share.

On Day 15, RIHCL made an announcement that it will generate present value of $16 million

after the takeover. REQUIRED: (a) Advise the management about the share prices of RIHCL and YCL on Day 1, Day 8 and

Day 15 at different levels of efficiency under the efficient markets hypothesis. (15 marks)

(b) One of the implications of efficiency of capital markets is related to the fair share price;

some modern corporate financial theories use efficient capital market as their basis.

Discuss this statement. (5 marks)

(Total: 20 marks)

End of Examination Paper

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